Canada: Penalties For False Statements Or Omissions – Part III

This issue of the Legal Business Report provides current
information to the clients of Alpert Law Firm on penalties under
the Income Tax Act (Canada) and the possible challenges to such
assessments. Alpert Law Firm is experienced in providing legal
services to its clients in tax and estate planning matters, tax
dispute resolution, tax litigation, corporate-commercial
transactions and estate administration. Howard Alpert, C.S. is
certified by the Law Society as a specialist in Corporate and
Commercial Law and as a specialist in Estates and Trusts
Law.

A. RECENT DEVELOPMENTS IN THE AREA OF PENALTIES

This memorandum deals with certain important developments in the
assessment of penalties. Specifically, the Courts have dealt with
the assessment of penalties as they relate to: (i) the reassessment
limitation period; (ii) non-capital loss carry forwards; (iii)
carry back of losses; and (iv) the capital gains exemption.

(i) LIMITATION PERIOD FOR MINISTER'S ASSESSMENTS &
REASSESSMENTS

As a general rule, the Minister of National Revenue (the
"Minister") may only assess or reassess a taxpayer within
the "normal reassessment period." Pursuant to subsection
152(3.1) of the Income Tax Act (the "Act"), the
normal reassessment period differs according to the taxpayer's
category. For mutual fund trusts and corporations that are
non-Canadian controlled private corporations, the limitation period
for reassessments is four years from the earlier of: (i) the date
of mailing of a notice of original assessment; and (ii) the date of
mailing the original notification that no tax is payable for the
taxation year. For all other taxpayers, the reassessment period is
three years from the earlier of the two dates stated above.

However, pursuant to paragraph 152(4)(a) of the Act, this
limitation period does not apply when the following two factors are
present: (i) there is an assessment or reassessment based upon a
misrepresentation by the taxpayer; and (ii) the taxpayer or the
person filing the return has made a misrepresentation that is
attributable to neglect, carelessness or willful default, or has
committed any fraud in filing the return or in the supplying of
information. Where the Minister has performed an assessment or
reassessment beyond the normal limitation period, the Minister has
the burden of proving, on a balance of probabilities,
misrepresentation or fraud on the part of the taxpayer.

Although the requirements for justifying subsection 163(2)
penalties and for disregarding the normal assessment period are
very similar, the Minister nevertheless must prove more in order to
impose penalties. To assess a taxpayer beyond the normal
reassessment period, it is sufficient to prove a failure to use
reasonable care, while penalties will only be justified if the
Minister can prove gross negligence on the part of the
taxpayer.

(ii) THE TREATMENT OF NON-CAPITAL LOSS CARRY-FORWARDS IN THE
CALCULATION OF PENALTIES

Penalties under subsection 163(2) of the Act are calculated, on
a percentage basis, according to the amount of tax payable on the
taxpayer's understatement of income. Specifically, the taxpayer
will be liable for a penalty of the greater of $100 and 50% of the
tax payable on the taxpayer's understatement of income. Case
law has indicated that once penalties are imposed, taxpayers very
often attempt to show the existence of legitimate previous
non-capital losses or expenses that could be attributed to the tax
period in question, in the hopes that such losses would reduce the
amount of understatement of income that their penalties will be
calculated on.

Until recently, the law has been vague as to whether such losses
or expenses should be used in the calculation of income for the
purposes of calculating penalties (and in effect reducing or
obliterating the amount of penalties to be paid), or whether
previous losses should be ignored in penalty calculation. Recent
case law has illuminated this ambiguous area. The Courts have said
that in calculating penalties, previous losses or expenses can be
used only if such losses or expenses are wholly applicable
to the unreported income (i.e. the non-capital expenses originate
from the same source as the unreported income).

Recently the Court has found that by the combined operation of
subparagraph 163(2)(a)(i) and paragraph 163(2.1)(a) of the Act,
previous losses that not applicable to the unreported income should
be ignored for the purposes of penalty calculation. As such, a
penalty may arise even in a year when unreported income is offset
by previous losses leaving no taxes to be paid by the taxpayer.

(iii) THE TREATMENT OF LOSS-CARRYBACKS IN THE CALCULATION OF
PENALTIES

As previously set out in this issue of Legal Business Report,
penalties under subsection 163(2) of the Act are calculated, on a
percentage basis, according to the amount of tax payable on the
taxpayer's understatement of income. Also, a taxpayer who
entirely fails to file a tax return, or who files a tax return
after the required time, can be subject to a penalty of 5% of the
unpaid tax, pursuant to subsection 162(1) of the Act.

However, loss-carrybacks cannot be used in determining
understatement of income for the purpose of penalty calculation.
Subsection 162(11) of the Act clearly indicates that for the
purpose of computing late-filing penalties under subsections 162(1)
and 162(2), the person's tax payable shall be determined
before taking into consideration items such as
loss-carrybacks, foreign tax credits and investment tax credits
from subsequent years.

Recent Court decisions have also been very clear in reiterating
that while subsequent losses and expenses can be used in the
calculation of taxable income, such loss-carrybacks cannot be used
in determining income tax owing for the purpose of calculating
penalties.

(iv) THE TREATMENT OF THE CAPITAL GAINS EXEMPTION

Capital gains arising on dispositions of qualifying shares of
small business corporations, as well as dispositions of qualified
farm property, are eligible for a lifetime capital gains exemption
of $800,000.00 pursuant to section 110.6 of the Act. The capital
gains exemption applies to Canadian resident individuals other than
trusts.

In recent cases, taxpayers who have been assessed for penalties
have claimed that they are entitled to the capital gains exemption,
in the hopes that such a deduction would reduce the income upon
which their taxes and penalties are calculated. However, the
Courts, pursuant to subsection 110.6(6) of the Act, have denied
such a claim, stating that if an individual fails to report a
capital gain knowingly or under circumstances amounting to gross
negligence, as proven by the Minister, then the individual will
lose the right to claim the exemption for the gain in the year of
disposition or any subsequent taxation year. As such, individuals
are prevented from: (i) claiming that the exemption can work to
reduce their understatement of income; and (ii) arguing that any
applicable penalties should be based on a tax liability which has
been reduced by the capital gains exemption.

As a result, the taxpayer will lose the benefit of the capital
gains exemption, both in the calculation of income and as a
deduction in the calculation of penalties.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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Another self styled educator with the Paradigm Education Group tax protester movement has been sentenced to a jail term for tax evasion and counselling others to evade as a result of a successful tax prosecution.

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